Applications of the Harrod-Domar theory
- To explain why some low income countries have failed to achieve take off, which Rostow suggested was the most important stage of growth. Take off is the movement into sustained economic growth brought about by increased saving which leads to increased investment. The savings are essential to fuel the self-sustaining growth.
- To explain ways of overcoming the barrier to take off imposed by low domestic savings.
Financial markets in developing economies
- Financial markets such as stock markets and banks are markets where interest rates act as the price that creates equilibrium in the market.
- In developing economies there are scarce savings. The rate of interest is therefore high to reflect this very small supply for banks to loan out to firms to invest.
- Therefore, were there developed financial markets, only projects with an equal or higher projected rate of return would take place. This mechanism means that only the most productive investment would be given the funds for it to go ahead. However, in many developing economies there are not developed financial institutions. This means that the "price mechanism" of interest rates that channels savings to the most productive allocation (though this may not always be the most socially beneficial allocation) in developed economies does not happen in developing economies.
Thus developing economies have trouble at each stage of the development cycle. There is a very low savings ratio due to low incomes, under developed financial markets for savings and the rival attraction of import consumption for those with money they could save. "Economic elites " choose to consume expensive imports instead of saving.
To get out of the cycle above an economy can take the following measures.
Investment in education offers external benefits and so financial markets would under allocate savings to such investments. This suggests a role for government intervention to ensure such investment takes place.
These notes form a homework given in a lesson on 24/09/2004.
